Lifetime Gifts Yield Estate and Gift Tax Savings

The federal gift tax annual exclusion currently allows each individual to give up to $14,000 each year to an unlimited number of donees – entirely free of tax. (Under the 1997 Tax Act, the amount of the exclusion is indexed to inflation and is rounded to the next lowest multiple of $1,000.) The exclusion is available for outright gifts and for gifts made to certain types of trusts. The effect of annual exclusion gifts is doubled for a husband and wife, who can make combined annual gifts of up to $28,000 to each child and grandchild. In addition, paying the medical expenses (including health insurance premiums) or the school tuition of another person is not a taxable gift if the payment is made directly to the healthcare provider or school. Making the latter types of gifts can significantly increase the amount that a donor can transfer free of gift or estate tax. Thus, each year a grandparent could pay a grandchild's full tuition and health-insurance costs and make $14,000 in other gifts to the grandchild without incurring any gift tax liability. Gifts are also favored under the income tax law – property received by way of gift or inheritance is not includible in the donee's income and generally has no adverse tax consequence.

Each Lifetime Gift of $14,000 Can Save $5,600 or More in Taxes

Annual exclusion gifts and gifts sheltered by the medical expense and tuition exclusions are not subject to estate tax when the donor dies. Because federal estate tax rates of 40 percent apply to taxable estates that exceed $5,450,000 in 2016, each $14,000 annual exclusion gift can save $5,600 or more in estate taxes. As the following example indicates, individuals who make tax-free gifts are able to pass substantially more property to their families and less to the IRS.

Example: In 2015 and 2016 Donor (D), a widower, gave $14,000 to each of two children and five grandchildren. By making the gifts, D removed $196,000 from his estate ($98,000 each year) without incurring any tax liability. In 2015 and 2016, D also paid the private school tuition of $15,000 per year for two of his grandchildren. The payments, which removed an additional $60,000 from his estate, also were not subject to the gift tax. In 2016 D died, leaving a taxable estate of $6 million, on which a federal estate tax of $220,000 will be due. If D had not made the gifts, D's estate would have included an additional $256,000 that would have been subject to an additional $102,400 in federal estate taxes. By making the gifts, D's beneficiaries will receive $102,400 more than if he had not made the gifts in 2015 and 2016. Each additional $14,000 annual exclusion, medical expense or tuition gift made by D would have saved $5,600 in estate taxes at the applicable 40 percent rate.

Choice of Property to Give Is Important; Basis for Gain or Loss

Selecting what property to give is particularly important because of the rules regarding the determination of the donee's basis in the gifted property. When property is sold or exchanged, the owner's gain or loss is usually determined by deducting the basis of the property (typically the initial cost of the property) from the amount received. For example, if an owner sells property for $15,000 that has a basis of $10,000, the owner has a gain of $5,000.

Basis – Don't Lose a Loss

Under the general rule, the donor's basis in property carries over to the donee. Thus, if a donor makes a gift of property that has a basis of $10,000 and a present value of $15,000, the donee will have a basis of $10,000 in the property. The basis of the grantor carries over so long as the value of the gift is at least equal to its basis. Under an important exception to the general rule, for the purpose of determining loss on the subsequent sale or exchange of the gifted property, the donee's basis in gifted property is limited to the value of the property at the time of the gift. Thus, if the donor gives property to a donee that has a basis of $10,000 but a value of only $5,000, for purposes of determining loss on a sale, the donee's basis in the property is limited to $5,000. That is, if the property were sold for $4,000 by the donee, the donee would have a loss of $1,000 – not $6,000. Because of this limitation, a donor generally should not give property that has declined in value and is worth less than its cost. Instead, the donor should consider either giving the donee other property or selling the depreciated property, getting the tax benefit of the capital loss, and giving the proceeds to the donee.

Basis of Inherited Property – Free Step Up in Basis at Death

The basis of inherited property is determined differently from gifted property: The basis of property received from a decedent is its estate tax value in the decedent's estate (usually its fair market value at the time of the decedent's death). As a matter of overall strategy, donors commonly make lifetime gifts of cash or slightly appreciated property and either retain highly appreciated assets until death or use such assets to make charitable gifts. For example, if a decedent has property in their estate with a fair market value of $15,000 and a basis of $10,000, the beneficiary of that property will have a basis of $15,000 in such property and there will be no built-in gain.

Gifts Can Also Save Generation-Skipping Transfer Taxes

The generation-skipping transfer tax ("GSTT"), enacted in 1986, imposes an additional tax on property transferred to "skip persons" (i.e., persons such as grandchildren or great-grandchildren who are two or more generations below the transferor's generation). The tax is imposed at the maximum estate tax rate (40 percent in 2016). Each person has a GSTT exemption of $5,450,000 in 2016, which is enough to shelter gifts made by most persons from the GSTT. However, the impact of the GSTT is so severe that it must be taken into account in planning large estates – particularly because the GSTT applies in addition to the gift or estate tax. Fortunately, the impact of the GSTT can also be reduced by making lifetime gifts. First, properly planned gifts of $14,000 or less that qualify for the annual gift tax exclusion are not subject to the GSTT. Second, medical expense and tuition payments made on behalf of grandchildren or great-grandchildren are also exempt from the GSTT.

The example discussed above can be modified to illustrate the effect of the GSTT:

If D had left $6 million of his $12 million estate to his grandchildren, the GSTT would apply to the extent the bequest exceeded his GSTT exemption. The GSTT on transfers made by D would be calculated as follows:

The lifetime gifts that D made to his grandchildren would have resulted in very large overall tax savings. Each gift that D made to his grandchildren saved both estate taxes (at an additional 40 percent rate) and the GSTT (at a 40 percent rate). Thus, the $200,000 in gifts that D made to his grandchildren saved approximately $160,000 in taxes – $80,000 of estate tax and $80,000 of GSTT.

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